The Canadian dollar has been relatively resilient in recent weeks, so I must be missing something. Current trends not only suggest that the loonie should be headed lower, there's a plausible scenario where the domestic currency might re-test the January lows below 70 cents (U.S.).
The dollar swung wildly Wednesday during Bank of Canada Governor Stephen Poloz's announcement on monetary policy. The currency jumped half a cent when no cut in rates was reported, but then slid all the way back as economic growth forecasts were reduced. Mr. Poloz also noted that the Bank had considered further measures to spur economic growth, a comment many interpreted as a signal that another cut in interest rates is ahead.
Central bank policy, as reflected in bond yields, has been the most powerful driver of the Canadian dollar's value in recent years – more so than oil prices. The accompanying chart shows that the loonie has been tracking the yield spread between Canadian and U.S. two-year government bonds (Government of Canada bond two-year yields minus two-year U.S. Treasury yields) almost exactly.
Monetary policy at the Federal Reserve and the Bank of Canada are moving in different directions, and the two-year spread is likely to fall further. The Fed is expected to raise interest rates in December, which will push U.S. bond yields higher relative to domestic bonds. A Bank of Canada rate cut will exacerbate this trend by pushing Canadian bond yields even lower.
It should be noted that a rate cut for Canada before the end of the year is unlikely. Bloomberg calculates a less than 10-per-cent probability, based on economists' forecasts. However, in recent days two major economists – David Watt from HSBC and Dana Peterson from Citibank – have predicted another Bank of Canada rate reduction for 2016. Combined with the hint of further stimulus from Mr. Poloz, the likelihood of lower rates by mid-2017 are clearly rising.
In the chart, the solid lines show the extremely close relationship between the value of the Canadian dollar and the difference in yield between domestic and U.S. two-year government bonds. The dotted line of the chart represents a scenario where both central banks change benchmark rates. There are a number of assumptions involved, so it should be viewed as just one possible scenario rather than a prediction.
The dotted line represents a 55 basis point decline in yield differential. I arrived at that number by looking at the Fed's last interest rate hike in December 2015, which caused a 15 basis point downward move in the black-coloured line. The Bank of Canada's two post-crisis interest rate hikes caused a 60 basis point and 20 basis point decline in relative yields – I took the average of the two and got 40 basis points. The 15 basis points added to 40 basis points is how I got to 55.
The obvious pattern in the solid lines is for the loonie to follow the path of relative yields. If that persists, and the 55 basis point decline in the black line happens, this suggests the loonie moving downwards towards the sub-70 cent levels of January 2016.
In the real world, of course, it's not this cut and dried. The oil price still has a major influence on the domestic currency's value and there's no guarantee that central bank policy changes will have the same effect on bond yields as in previous cases. My hope, however, is that this analysis highlights the loonie's precarious position when U.S. and Canadian central bank policies are leaning in different directions.
Friday's action in currency markets, which saw the loonie fall more than half a cent to 75.04 cents (U.S.), could be just a sign of things to come.